I’ve heard, Richard, that you are interested in the distinction I’ve been
making between an economic contraction and a monetary deflation. You’ve had
a few items on “deflation” in the Spectator since you became editor
several months ago, but I’m afraid they were either mostly incorrect or a
bit off the mark. You have hit on exactly the right point, though, in wanting
to learn about deflation by hearing why it is different from
“contraction.” Believe it or not, I actually discussed this topic with
Treasury Secretary Paul O’Neill when I met with him and some of his staffers
in April, as I only had a half hour with him to make my deflation argument. If
you study economics these days, you will not be taught the distinction, but if
you want to figure out why the stock market and the economy are in trouble,
you must understand the deflation process exactly, for it is a process,
not an economic statistic. Let me try:

First of all, in a supply-side model, consumers of goods and services are
peripheral, not primary. By that I mean that producers of goods -- those who
supply them to the marketplace -- are the primary actors. They produce in
order to exchange their surplus output with producers of other goods and
services. As I explained it to O’Neill: If he is a producer of bread and I
am a producer of wine, and we are planning to exchange our surplus output with
each other over a period of time, in a modern economy, this is done through
the intermediation of banks and financial markets, not barter. If there is a
surprise to the markets in the form of a higher tax on producers of wine and
producers of bread, or a higher tariff between domestic producers of one and
foreign producers of another, there will be some exchange of goods that will
be uneconomic. Instead of being exchanged, they will pile up in inventories. This
is a contraction, not a deflation. Prices will fall as the producers
discount them in order to get them off the shelves, but this is only a
temporary condition. When it is a small event, we write it off as an inventory
recession, for as soon as the surpluses are liquidated, the rest of the
economy bounces back at the old price structure. The Great Depression was a contraction,
not a deflation. It was not caused by the Federal Reserve making dollars
scarce relative to gold, the proxy for all commodities. It was caused by
tariff and tax shocks that erected barriers between domestic producers and
between exporters and importers.

When the Great Depression was over, the general price level gradually returned
to higher levels. Because President Franklin Roosevelt had changed the dollar
value of gold in 1934, raising it to $35 per ounce from $20.67 per ounce, the
price level climbed higher than it had been in the 1920s. Professional
economists failed to see this post-World War II inflation had been part of the
inflationary process that began with the 1934 FDR devaluation.

Inflations and deflations only can be understood as process phenomena. When
Roosevelt raised the dollar/gold price by executive order, the general price
level took two decades to catch up with gold. This is because contracts had to
unwind in a gradual inflationary spiral between capital and labor. When the
debt structure of an economy is mature, it takes a long time for the process
to be completed. The same is true of deflation, which is what we are
experiencing today. As I explained to Secretary O’Neill, our honest attempts
to produce bread and wine and exchange surpluses with each other via financial
intermediation will be messed up by either a deflation or an inflation. If our
contract is such that I deliver him a loaf of bread every day, with the
contract requiring him to deliver the wine all at once at the end of a year,
the government must keep the dollar constant against gold in that period, for
if it deflates, O’Neill, who is in my debt, will be required to give me much
more wine than he anticipated at the outset. If the dollar inflates, as his
creditor, I will be forced to steadily increase the amount of bread I give
him, and at the end of the year will have to be satisfied with much less wine.
In a world where the unit of account is floating against the real world of
commodities, gold being the most sensitive proxy to monetary error, inflations
and deflations will be the rule, not the exception.

As wise a man as he is, Fed Chairman Alan Greenspan has not been wise enough
to realize the problems he caused by ending the dollar inflation, only to
preside over the dollar deflation that is now forcing down the general price
level. I’ve told friends that it is as if he threw a cigarette butt into the
brush back in November 1996, when the process began, and it has been burning
its way through commodity producers ever since, but is now reaching up the
mountain toward our production of intellectual goods and services. It is nice
to be a commodity producer at the beginning of an inflationary process, but
the flames finally reach you too. In a deflation, it is nice to be an
intellectual producer -- producing goods and services out of your head, not
out of the earth. But the flames finally reach you as the general price level
adjusts. This is what is happening to our economy today, although Greenspan is
doing everything he can to persuade his friends in the Bush administration
that it ain’t a deflation, and that with only a little more patience, the
tax cuts and his interest-rate cuts will cause the inventories to be
liquidated and we will have prosperity in the rebound that follows.

We can not undo the damage that has been done, Richard, but we can prevent the
damage that is yet to come as the deflation unfolds. Think of it as a
firebreak, devaluing the dollar against gold with a mini-inflation that takes
the gold price to $325, the number suggested by Jack Kemp several weeks ago
when he wrote about the deflation in The Wall Street Journal. When we
get there, we should probably consult with the rest of the world on how to
rebuild the international monetary system so that we do not have a floating
unit of account any more, but a dollar as good as gold, which does not inflate
or deflate.